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16.3 Warranty Liability of Parties

Learning Objectives

  1. Understand that independent of contract liability, parties to negotiable instruments incur warranty liability.
  2. Know what warranties a person makes when she transfers an instrument.
  3. Know what warranties a person makes when he presents an instrument for payment or acceptance.
  4. Understand what happens if a bank pays or accepts a check by mistake.

Overview of Warranty Liability

We discussed the contract liability of primary and secondary parties, which applies to those who sign the instrument. Liability arises a second way, too—by warranty. A negotiable instrument is a type of property that is sold and bought, just the way an automobile is, or a toaster. If you buy a car, you generally expect that it will, more or less, work the way cars are supposed to work—that’s the implied warranty of merchantability. Similarly, when an instrument is transferred from A to B for consideration, the transferee (B) expects that the instrument will work the way such instruments are supposed to work. If A transfers to B a promissory note made by Maker, B figures that when the time is right, she can go to Maker and get paid on the note. So A makes some implied warranties to B—transfer warranties. And when B presents the instrument to Maker for payment, Maker assumes that B as the indorsee from A is entitled to payment, that the signatures are genuine, and the like. So B makes some implied warranties to Maker—presentment warranties. Usually, claims of breach of warranty arise in cases involving forged, altered, or stolen instruments, and they serve to allocate the loss to the person in the best position to have avoided the loss, putting it on the person (or bank) who dealt with the wrongdoer. We take up both transfer and presentment warranties.

Transfer Warranties

Transfer warranties are important because—as we’ve seen—contract liability is limited to those who have actually signed the instrument. Of course, secondary liability will provide a holder with sufficient grounds for recovery against a previous indorser who did not qualify his indorsement. But sometimes there is no indorsement, and sometimes the indorsement is qualified. Sometimes, also, the holder fails to make timely presentment or notice of dishonor, thereby discharging a previous indorsee. In such cases, the transferee-holder can still sue a prior party on one or more of the five implied warranties.

A person who receives consideration for transferring an instrument makes the five warranties listed in UCC Section 3-416. The warranty may be sued on by the immediate transferee or, if the transfer was by indorsement, by any subsequent holder who takes the instrument in good faith. The warranties thus run with the instrument. They are as follows:

  1. The transferor is entitled to enforce the instrument. The transferor warrants that he is—or would have been if he weren’t transferring it—entitled to enforce the instrument. As UCC Section 3-416, Comment 2, puts it, this “is in effect a warranty that there are no unauthorized or missing indorsements that prevent the transferor from making the transferee a person entitled to enforce the instrument.” Suppose Maker makes a note payable to Payee; Thief steals the note, forges Payee’s indorsement, and sells the note. Buyer is not a holder because he is not “a person in possession of an instrument drawn, issued, or indorsed to him, or to his order, or to bearer, or in blank,” so he is not entitled to enforce it. “‘Person entitled to enforce’ means (i) the holder, (ii) a non-holder in possession of the instrument who has the rights of a holder [because of the shelter rule]” (UCC, Section 3-301). Buyer sells the note to Another Party, who can hold Buyer liable for breach of the warranty: he was not entitled to enforce it.
  2. All signatures on the instrument are authentic and authorized. This warranty would be breached, too, in the example just presented.
  3. The instrument has not been altered.
  4. The instrument is not subject to a defense or claim in recoupment of any party that can be asserted against the warrantor. “Recoupment” means to hold back or deduct part of what is due to another. The Official Comment to UCC Section 3-416 observes, “[T]he transferee does not undertake to buy an instrument that is not enforceable in whole or in part, unless there is a contrary agreement. Even if the transferee takes as a holder in due course who takes free of the defense or claim in recoupment, the warranty gives the transferee the option of proceeding against the transferor rather than litigating with the obligor on the instrument the issue of the holder-in-due-course status of the transferee.”
  5. The warrantor has no knowledge of any insolvency proceeding commenced with respect to the maker or acceptor or, in the case of an unaccepted draft, the drawer. The UCC Official Comment here provides the following: “The transferor does not warrant against difficulties of collection, impairment of the credit of the obligor or even insolvency [only knowledge of insolvency]. The transferee is expected to determine such questions before taking the obligation. If insolvency proceedings…have been instituted against the party who is expected to pay and the transferor knows it, the concealment of that fact amounts to a fraud upon the transferee, and the warranty against knowledge of such proceedings is provided accordingly.”Uniform Commercial Code, Section 3-416, Official Comment 4.

Presentment Warranties

A payor paying or accepting an instrument in effect takes the paper from the party who presents it to the payor, and that party has his hand out. In doing so, the presenter makes certain implied promises to the payor, who is about to fork over cash (or an acceptance). The UCC distinguishes between warranties made by one who presents an unaccepted draft for payment and warranties made by one who presents other instruments for payment. The warranties made by the presenter are as follows.Uniform Commercial Code, Section 3-417.

Warranties Made by One Who Presents an Unaccepted Draft

  1. The presenter is entitled to enforce the draft or to obtain payment or acceptance. This is “in effect a warranty that there are no unauthorized or missing indorsements.”Uniform Commercial Code, Section 3-417, Comment 2. Suppose Thief steals a check drawn by Drawer to Payee and forges Payee’s signature, then presents it to the bank. If the bank pays it, the bank cannot charge Drawer’s account because it has not followed Drawer’s order in paying to the wrong person (except in the case of an imposter or fictitious payee). It can, though, go back to Thief (fat chance it can find her) on the claim that she breached the warranty of no unauthorized indorsement.
  2. There has been no alteration of the instrument. If Thief takes a check and changes the amount from $100 to $1,000 and the bank pays it, the bank can recover from Thief $900, the difference between the amount paid by the bank and the amount Drawer (customer) authorized the bank to pay.Uniform Commercial Code, Sections 3-417(2) and (b). If the drawee accepts the draft, the same rules apply.
  3. The presenter has no knowledge that the signature of the drawer is unauthorized. If the presenter doesn’t know Drawer’s signature is forged and the drawee pays out on a forged signature, the drawee bears the loss. (The bank would be liable for paying out over the forged drawer’s signature: that’s why it has the customer’s signature on file.)

These rules apply—again—to warranties made by the presenter to a drawee paying out on an unaccepted draft. The most common situation would be where a person has a check made out to her and she gets it cashed at the drawer’s bank.

Warranties Made by One Who Presents Something Other Than an Unaccepted Draft

In all other cases, there is only one warranty made by the presenter: that he or she is a person entitled to enforce the instrument or obtain payment on it.

This applies to the presentment of accepted drafts, to the presentment of dishonored drafts made to the drawer or an indorser, and to the presentment of notes. For example, Maker makes a note payable to Payee; Payee indorses the note to Indorsee, Indorsee indorses and negotiates the note to Subsequent Party. Subsequent Party presents the note to Maker for payment. The Subsequent Party warrants to Maker that she is entitled to obtain payment. If she is paid and is not entitled to payment, Maker can sue her for breach of that warranty. If the reason she isn’t entitled to payment is because Payee’s signature was forged by Thief, then Maker can go after Thief: the UCC says that “the person obtaining payment [Subsequent Party] and a prior transferor [Thief] warrant to the person making payment in good faith [Maker] that the warrantor [Subsequent Party] is entitled to enforce the instrument.”Uniform Commercial Code, Section 3-417(d). Or, again, Drawer makes the check out to Payee; Payee attempts to cash or deposit the check, but it is dishonored. Payee presents the check to Drawer to make it good: Payee warrants he is entitled to payment on it.

Warranties cannot be disclaimed in the case of checks (because, as UCC Section 3-417, Comment 7, puts it, “it is not appropriate to allow disclaimer of warranties appearing on checks that normally will not be examined by the payor bank”—they’re machine read). But a disclaimer of warranties is permitted as to other instruments, just as disclaimers of warranty are usually OK under general contract law. The reason presentment warranties 2 and 3 don’t apply to makers and drawers (they apply to drawees) is because makers and drawers are going to know their own signatures and the terms of the instruments; indorsers already warranted the wholesomeness of their transfer (transfer warranties), and acceptors should examine the instruments when they accept them.

Payment by Mistake

Sometimes a drawee pays a draft (most familiarly, again, a bank pays a check) or accepts a draft by mistake. The UCC says that if the mistake was in thinking that there was no stop-payment order on it (when there was), or that the drawer’s signature was authorized (when it was not), or that there were sufficient funds in the drawer’s account to pay it (when there were not), “the drawee may recover the amount paid…or in the case of acceptance, may revoke the acceptance.”Uniform Commercial Code, Section 3-418. Except—and it’s a big exception—such a recovery of funds does not apply “against a person who took the instrument in good faith and for value.”Uniform Commercial Code, Section 3-418(c). The drawee in that case would have to go after the forger, the unauthorized signer, or, in the case of insufficient funds, the drawer. Example: Able draws a check to Baker. Baker deposits the check in her bank account, and Able’s bank mistakenly pays it even though Able doesn’t have enough money in his account to cover it. Able’s bank cannot get the money back from Baker: it has to go after Able. To rephrase, in most cases, the remedy of restitution will not be available to a bank that pays or accepts a check because the person receiving payment of the check will have given value for it in good faith.

Key Takeaway

A transferor of a negotiable instrument warrants to the transferee five things: (1) entitled to enforce, (2) authentic and authorized signatures, (3) no alteration, (4) no defenses, and (5) no knowledge of insolvency. If the transfer is by delivery, the warranties run only to the immediate transferee; if by indorsement, to any subsequent good-faith holder. Presenters who obtain payment of an instrument and all prior transferors make three presenter’s warranties: (1) entitled to enforce, (2) no alteration, (3) genuineness of drawer’s signature. These warranties run to any good-faith payor or acceptor. If a person pays or accepts a draft by mistake, he or she can recover the funds paid out unless the payee took the instrument for value and in good faith.

Exercises

  1. What does it mean to say that the transferor of a negotiable instrument warrants things to the transferee, and what happens if the warranties are breached? What purpose do the warranties serve?
  2. What is a presenter, and to whom does such a person make warranties?
  3. Under what circumstances would suing for breach of warranties be useful compared to suing on the contract obligation represented by the instrument?
  4. Why are the rules governing mistaken payment not very often useful to a bank?